The Federal Reserve will make an eagerly awaited decision on US interest rates on Wednesday. It is expected that interest rates will rise, following strong employment and wage growth in November. 211,000 jobs were created and wages are growing at a healthy 2.3% on an annual basis, leading markets to predict that the probability of a rate rise is around 80%.
Figure 1: Probability of Fed Raising Rates
Source: Financial Times
A rate rise in the UK is unlikely to follow in the immediate term. US core inflation – which discounts volatile items – is near target at around 1.9%, whereas the UK’s core rate remains well below target at 1.1%. This means that inflationary pressures are not as much of a current concern. However, the psychological impact of a US rate rise is likely to be significant for UK policymakers. US interest rates have not risen for nearly a decade, and interest rates in the UK have been at 0.5% since 2009 – a 300 year record low.
A continuation of a 0.5% base rate poses risks for the UK. Persistently low interest rates lead to a misallocation of capital, where companies are incentivised to undertake borrowing for unworthy investments. This has, in part, led to global corporate debt growing from $38 trillion to $56 trillion since 2007, according to McKinsey.
There are also a number of UK specific risks from continued low interest rates. BNP Paribas Real Estate Research has recently warned that failure to increase rates in 2016 could lead to a credit boom similar to that observed in the early 2000s. UK household debt to income ratios are already high relative to other developed nations, and the Office for Budget Responsibility is projecting an increase in household debt ratios over the next six years. This concerning trend could be exacerbated by holding interest rates at record lows.
Figure 2: Household Debt to Disposable Income Ratios
Source: Bank of England
Although UK inflation is currently at around zero, inflation is projected to rise over the coming months. Future wage growth and the oil price shock ‘washing through’ are likely to cause inflationary pressures. Given the UK’s Monetary Policy Committee (MPC) needs to anticipate the path of inflation over the next two years when deciding interest rates, there is a strong case for increasing rates sooner rather than later.
The Bank of England Governor Mark Carney has said that “when Bank Rate rises occur, they can be expected to be limited and gradual”. These limited and gradual increases to interest rates cannot be put off for much longer. To protect the UK’s economic health, the MPC should start raising rates in 2016.